University of Navarra. Research Seminar DOES SOCIAL PERFORMANCE REALLY LEAD TO FINANCIAL PERFORMANCE? ACCOUNTING FOR ENDOGENEITY

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1 University of Navarra Research Seminar DOES SOCIAL PERFORMANCE REALLY LEAD TO FINANCIAL PERFORMANCE? ACCOUNTING FOR ENDOGENEITY Roberto Garcia Castro, PhD. IESE Business School LMU - CAMS Munich, December,

2 Contents Does social performance really lead to financial performance? Accounting for endogeneity Presentation overview Research topic and question. Paper s Motivation. Methodological issues. Endogeneity. Presentation of the panel data. KLD. Main findings and results. Contribution and managerial implications

3 Research question and paper motivation DOES SOCIAL PERFORMANCE REALLY LEAD TO FINANCIAL PERFORMANCE? ACCOUNTING FOR ENDOGENEITY The investigation of the relationship between the firm and its stakeholders can be done following a: Normative approach Evan & Freeman, 1983; Freeman, 1984, 1994; Goodpaster, 1991; Clarkson, 1994; Donaldson & Preston, 1995; Argandoña, 1998; Donaldson & Dunfee, 1999 Philips, Instrumental approach Freeman, 1984; Hill & Jones, 1992; Jones, 1995; Jones and Wicks, 1999 It is taken to be a practical necessity that stakeholder theory revolve around financial consequences substantive enough to convince managers that stakeholders are worthy of attention (Margolis and Walsh, 2003).

4 Research question and paper motivation Recent extensive reviews of the SP-FP empirical literature Margolis and Walsh [127] (2003); Orlitzky et al. [52] (2003); Roman et al. [51] (1999); Griffin and Mahon [62] (1997); Pava and Krausz [21] (1996). Margolis & Walsh (2003) identify 127 empirical studies since 1972 on SP-FP. 109 studies with SP as independent variable: 54 (+) 20 (mixed results) 28 non significant Only 7 (-) - Overall, the evidence concludes there is a positive relationship (+) - Different measures of SP: - Rating agencies (KLD, SAM, GMI, AccountAbility) - Reputation indices (fortune reputation, Reputation institute) - Pollution indices (e.g., CEP --Council of economic priorities) - Annual reports analysis (content analysis techniques) - ad-hoc indices, questionnaires, etc. - KLD is one of the most often used indexes in the literature (>10 studies).

5 Research question and paper motivation Overall, the evidence concludes there is a positive relationship, but If the SP-FP relationship is +, then: what is it adding a stakeholder view of the firm? The instrumentalization of stakeholder theory challenges the normative and ethical foundations of stakeholder arguments. Managers do not justify their social actions because they are right or consistent with principles but because they are profitable according to the empirical findings Moreover, the positive link contradicts the common observation that firms are often at odds with their stakeholders

6 Methodological Issues. Endogeneity Possible explanations for the empirical findings: (other than Business and Society sponsors) 1. Measurement problems with SP 2. Distinction between short- and long run 3. Incomplete measurement of FP and total value creation (Lieberman et al., 2006) 4. Reverse causality (e.g., slack resources hypothesis) 5. Self-selection (endogeneity) of strategic choice Previous research in strategic management and finance has shown the importance of correcting for endogeneity (Hamilton & Nickerson, 2003; Campa & Kedia, 2002; Villalonga, 2002). The empirical results may change. The adoption of CSR policies may be correlated with an unobservable firm specific attribute (quality of management, top management values,). E(π 0 SP 0 ) E(π 0 SP 1 ) and, E(π 1 SP 1 ) E(π 1 SP 0 )

7 Methodological Issues. Endogeneity Previous research estimates: π it = γsp it + X it β + ε i But if the cov (SP i, ε 1i ) 0 then, unobserved factors affect both the strategic choice of SP and performance simultaneously OLS cross-sectional estimation produces a biased estimate of the effect of SP on FP Panel data: panel data fixed effects estimation can control for firm-specific unobservable attributes π it = γsp it + X it β +θ i + ζ it ε = θ i +ζ it A panel allows us to estimate: (unobs. constant) π it -π it-1 = γ(sp it -SP it-1 ) + (X it -X it-1 )β + (ζ it -ζ it-1 ) Instrumental variables: SP= f (activist s pressure, visibility, sector, governance) (unobs. is variable). SP it =βz it + µ it

8 Methodological Issues. Endogeneity A note on Hausman test First, we need to test if endogeneity in our sample is a problem or not Hausman test does not work in many situations! Standardizing the X s could help Alternative: Mundlak test π it = γ 1 SP it + γ 2 SP i + X it β + ε i

9 Methodological Issues. Endogeneity Life expectancy Red meat consumption

10 Methodological Issues. Endogeneity Life expectancy Red meat consumption

11 Presentation of the panel. KLD. Methods and Data KLD and Datastream panel data. 17,000 firm-years observations US firms KLD (Kinder, Lydenberg, Domini & Co. Inc.) index : Employees Community Environment Customers Minorities KLD data on corporate governance

12 Presentation of the panel. KLD.

13 Strengths Product Quality R&D/Innovation Benefits the Economically Disadvantaged Other Strength Environment Clean Energy Beneficial Products & Services Pollution Prevention Recycling Other Strength Employee Relations Cash Profit Sharing Employee Involvement Health and Safety Strength Retirement Benefits Strengths Union Relations Strength Other Strength Community Charitable Giving Strength Innovative Giving Non-US Charitable Giving Support for Housing Support for Education Volunteer Programs Other Strength Diversity CEO Promotion Board of Directors Work/Life Benefits Women & Minority Contracting Employment of the Disabled Gay & Lesbian Policies Other Strength Concerns Product Safety Marketing/Contracting Controversies Antitrust Disputes Other Concern Hazardous Waste Regulatory Problems Ozone Depleting Chemicals Substantial Emissions Agricultural Chemicals Climate Change Other Concern Union Relations Concern Health and Safety Concern Workforce Reductions Retirement Benefits Concern Other Concern Negative Economic Impact Investment Controversies Tax Disputes Other Concern Controversies Non-Representation Ownership Concern Other Concern

14 Presentation of the panel. KLD. Some firms in the sample according to their stakeholder management score # Stakeholder Management Company 6 Ben & Jerry's Homemade, Inc. 40 Eastman Kodak Company 51 Southwest Airlines Co. 62 Deere & Company 72 Medtronic, Inc. 193 Enron Corp. 563 Raytheon Company 582 WorldCom, Inc. 623 Lockheed Martin Corporation 630 Tyco International Ltd.

15 Main findings and results STUDY Waddock and Graves (1997b) Comparison of the Effects of KLD on Financial Performance Williams and Siegel (2000) Hillman and Keim (2001) García-Castro, Ariño and Canela (2006) WG ROA ROE ROS Accounting measure WS Accounting measure HK *p< 0.10; **p< 0.05; ***p< Very few firms only 13 changed from one industry to a different one during the panel period. For that reason we decided to treat industry as a time invariant variable. Only time-for that reason, industry dummies do not apply to the case of fixed-effects models as only time-varying variables can be estimated in those models. 2 MVA is measured in $ Millions. 3 Although we use the notation OLS, in the four OLS models in GAC we are doing pooled cross-sectional OLS estimation. GAC (MVA) ROE ROA MVA 2 TobinQ OLS OLS OLS OLS OLS OLS OLS 3 FE OLS 3 FE OLS 3 FE OLS 3 FE KLD.024*** **.141*** ** 1.509*** ***.125* 1995*** *** -.132* Beta No No No Yes Yes Size -.502E-6*.136E E-6 Yes Yes -.202** 2.25e e e-8*** -3.27e-8***.0003*** e e-9 Industry Dummies Yes Yes Yes No Yes Yes Yes n/a 1 Yes n/a 1 Yes n/a 1 Yes n/a 1 R&D intensity No No No No.263*** No ** *** *** *** 47492*** ** leverage -.120*** -.471*** -.115*** No No No.007***.006*** * ** ***.006*** R Adjusted R F-statistic 11.55*** 2.20*** 6.99*** *** 8.97*** 12.85*** 27.73*** 93.66*** 19.17*** 35.16*** 20.65*** 90.20*** No. of observations (firm-year obs.) (3334) (3334) (3462) (3462) (2928) (2928) (2920) (2920)

16 Main findings and results Table 4. OLS estimates for KLD Coefficient Standard error LEC OWS TRS SP500 (3 lag) * Industry dummies 1 R 2 F-statistic *** *** Observations 2974 *p< 0.10; **p< 0.05; ***p< 0.01 LEC: Limited executive compensation OWS: Ownership strength TRS: Transparency in social and environmental reporting SP500: dummy variable. 1 if the company is listed in the S&P500 index, otherwise, 0. 1 A total of 37 dummies representing 37 different industries were introduced in the model.

17 Main findings and results Table 5. Instrumental variable (IV) estimation ROE 1 ROA 1 MVA 1 Tobin s Q 1 IV IV IV IV KLD Beta Size 4.77e e e-9 R&D intensity Leverage R Adjusted R F-statistic No. of observations (firm-year obs.) 6.15*** *** *** *** *p< 0.10; **p< 0.05; ***p< The difference between the firm s performance for each year and the average of the industry it belongs to for each year is used as the dependent variable for ROE, ROA, MVA and Tobin s Q, respectively. 2 KLD has been instrumented using the variables in the model shown in Table 4 above: LEC, OWS, TRS, industry dummies and SP

18 3Com Corporation AGL Resources Inc. ALLTEL Corporation ALZA Corporation AMP, Inc. AMR Corporation k ld ASARCO Incorporated AT&T Corp. Abbott Laboratories Graphs by firm year

19 Southwest Airlines Co year kld roe Graphs by firm Delta Air Lines, Inc year kld roe Graphs by firm

20 Contribution and managerial implications Contributions Findings The positive significant impact of SP on FP disappears once endogeneity is properly taken into account There are unobserved variables correlated with both SP and FP that mediate the SP-FP relationship Quality of management? (non measurable but observable?) Managerial Implications 11 Managers should not assume that investing in SP will lead to higher FP In the absence of instrumental reasons for adopting social policies they need to find normative rationales Distinction between short run (-) and long run (+)

21 CG Business & Society CSR Firm Level: Corporate governance Stakeholder management Shareholder value creation Stakeholder value Long-term performance Individual level: Interpersonal cooperation Trust, motivation Individual decision making Ethics Research Agenda Research papers: Garcia-Castro, R., Ayuso, S., Ariño, M.A and Rodriguez, M.A Corporate governance and labor management: A cross-national study of firm governance and employment contracts. Academy of Management Conference, Strategic Management Society, Forthcoming publication in BEER, Garcia-Castro, R. and Ariño, M.A Is superior economic performance the same as sustained competitive advantage? The case of Southwest Airlines. Presented at Academy of Management Conference and Atlanta Competitive Advantage Conference (ACAC), Review & resubmit at SMJ. Garcia-Castro, R., Canela, M.A. & Ariño, M.A Over the long run? The impact of stakeholder management on short run and long run shareholder value creation. Review and resubmit at Business & Society. Ariño, M.A, Ariño, A. and Garcia-Castro, R A model to evaluate transient industry effects. Forthcoming publication, Managerial and Decision Economics. Garcia-Castro, R., et al Maximising stakeholders interests: An empirical analysis of the stakeholder approach to corporate governance, Working paper. Paper presented at Strategic Management Society (SMS), Research papers: Garcia-Castro, R Managerial constraints and the idea of the firm as a cooperative system. Working paper. García-Castro, R. & Ariño, M.A Identification-based trust and competitive advantage. Paper presented at the European Academy of Management (EURAM) annual conference, Munich, 2005.

22 Universidad de Navarra